I Spy … Put/Call Ratio Soaring to Highest Level since October

Option traders are acting irrational.

On March 30, the CBOE equity put/call ratio fell to the lowest level of 2015.

Just three days later (April 2), the put/call ratio soared to the highest level since October 2014.

In fact, the chart shows a near perfect ‘V’ with all three touch points representing some sort of extreme.

Sunday night’s Profit Radar Report published a similar chart and noted that: “The equity put/call ratio just spiked to the highest level since last October. Option traders are expecting lower prices. As the chart shows, usually when that’s the case, the S&P 500 does the opposite.”

The S&P 500 cash index (NYSEArca: SPY) doesn’t fully reflect the volatility since Friday’s job report, but the S&P 500 futures spiked from their 2,043 low on Sunday to 2,075 today.

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The S&P 500 may or may not be done punishing bearish option traders, but the volatility of the put/call ratio cautions that it may not take too much of a rally to work off last week’s bearish (bullish for stocks) put/call extreme.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

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Equity Put/Call Ratio at 41-Month Low, but Risk of ‘Black Swan’ Event Limited

Last week the CBOE Equity Put/Call ratio slipped as low as 0.43, the lowest level since January 2011. Similar readings in April 2010 and April 2012 led to nasty sell offs? But something is different this time.

Last week the CBOE Equity Put/Call ratio plunged to 0.43, the lowest reading since January 2011. This wasn’t just a one-day fluke as the 5-day SMA fell as low as 0.518, also a 41-month extreme.

A ratio of 0.43 means that option traders bought 2.3 calls (bullish option bet) for every put (bearish option bet). Option traders don’t have a ‘smart money’ reputation.

The chart below, featured in the June 11 Profit Radar Report, plots the S&P 500 (SNP: ^GSPC) against the 5-and 10-day SMA of CBOE Equity Put/Call ratio.

As the dashed red lines highlight, low put/call ratio levels led to S&P 500 (NYSEArca: SPY) weakness more often than not.

Is the Put/Call Ratio Warning of a Crash?

Lately, there’s been much talk about a crash or major correction. Does the current equity put/call ratio foreshadow such a crash or correction?

Looking at the put/call ratio in isolation one could conclude that there’s a high chance of a 1%+ correction. Why?

Similar equity put/call ratio readings in April 2010 and April 2012 were followed by nasty sell offs (see red shadows).

But let’s expand our analysis to include the CBOE SKEW Index. The SKEW Index basically estimates the probability of a large decline (2 standard deviations or ‘Black Swan’ event).

Readings of 135+ suggest a 12% chance of a large decline. Readings of 115 or less suggest a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

Last week the SKEW finished at 127.78, which is above average, but well below its January peak of 139.62.

The April 2010 and April 2012 highs saw SKEW readings of 134 and 139 (shaded areas).

The relative SKEW anemia softens the generally bearish message of the put/call ratio, but it doesn’t eliminate all the risk.

The Profit Radar Report’s 2014 S&P 500 Forecast (published on January 15), projected a pre-summer high at S&P 1,950. Last week the S&P reached 1,950 and pulled back. What does this mean for the rest of the year?

A complimentary look at the updated 2014 S&P 500 Forecast is available here:

Updated 2014 S&P 500 Forecast

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The ‘Smart Dumb Money’ is Market-Top-Worthy Bullish

Stocks caught a decent bid on strong breadth on Monday, but one accurate ‘dumb money’ indicator hit bullish extremes not seen since early 2011. This is a serious red flag as the featured chart clearly shows.

I always follow multiple indicators, especially when we’ve got ‘skin in the game.’

As per the August 28 Profit Radar Report, we went long the S&P 500 at 1,642.

Our up side target was an open chart gap at S&P 1,685. Open gaps pull price like a magnet. The S&P 500 is within striking distance of the open gap, and according to option traders risk is rising.

On Tuesday the CBOE Equity Put/Call Ratio dropped to 0.45, the lowest reading since early 2011 (blue line). This means that option traders are buying more than two calls for every put, a bullish extreme.

The 10-day SMA for the put/call ratio is at 0.566, the lowest since the May 2012 high.

What does such a low equity put/call ratio mean? 

Back in April 2010 the put/call ratio fell as low as 0.32 and I sent out the following warning and explanation to subscribers on record:

“The put/call ratio can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses incurred by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

Just a couple of weeks later the S&P 500 (SNP: ^GSPC), Nasdaq, and Dow Jones spiraled lower in what was later dubbed the ‘Flash Crash.’

Obviously, the current reading is not as bad as in April 2010, but as the chart below shows it is at a level that’s led to lower prices all but once (with or without delay) since 2011. The one exception occurred in January 2012.

What to Do?

The Nasdaq (Nasdaq: QQQ) has rallied to new highs. This seems bullish, but seasonality for AAPL is soon turning bearish. The S&P’s up side target for the rally from the August 28 low – 1,627 for the S&P 500, 163 for SPY (NYSEArca: SPY) – is just a few points away. In short, risk is rising.

This doesn’t mean that prices can’t move any higher, but it’s prudent to lock in gains or raise stop-loss levels.

A stunning long-term outlook that puts the current rally into context is available to subscribers of the Profit Radar Report.

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter at iSPYETF

Is a Market Top Near? ‘Smart’ Option Traders Send a Curious Message

Option trader sentiment extremes have racked up a fairly impressive track record as a contrarian indicator in the Fed’s QE bull market. No one else is talking about a major market top, so now might be an appropriate time to ‘check in’ with option traders and see what they have to say.

The QE bull market is 53 months old. The S&P 500 trades 156% higher today than at its March 2009 low, the Nasdaq-100 and Russell 2000 are up 209%.

No one else in the mainstream media is calling for a top, which is all the more reason to open this particular can of worms: Is a market top near?

One specific segment of traders has offered valuable clues about approaching market tops in the past: Option traders.

Equity Put/Call Ratio

The Equity Put/Call Ratio and SKEW Index capture the actions of the kind of option traders considered ‘dumb money’ (please don’t shoot the messenger, I didn’t come up with the term).

The Equity Put/Call Ratio shows the put volume relative to call volume. A ratio above 1 occurs when put volume exceeds call volume. The ratio is below 1 when call volume exceeds put volume.

Puts are bought to protect portfolios against declines; calls are bought as a bet on higher prices.

Since this is a contrarian indicator, high readings (0.9 or above) are usually seen near market bottoms when fear of a decline runs high. Readings around or below 0.5 reflect a dangerous extent of complacency and occur near market highs.

Last week the Put/Call Ratio fell as low as 0.55%. What does that mean?

The chart below plots the S&P 500 (NYSEArca: SPY) against the equity Put/Call Ratio (bottom of chart) and the SKEW Index (more about the SKEW in a moment).

The vertical red lines highlight readings at market tops.

When viewed in the context, the current Equity Put/Call Ratio is approaching a level that’s caused trouble for stocks in the past.
This note, which I sent to subscribers on April 16, 2010 explains exactly why: “The put/call ratio can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses accrued by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.
This note preceded the 2010 ‘Flash Crash’ by only 13 days.
The current reading doesn’t foreshadow a Flash Crash, but a degree of caution is warranted.
SKEW Index
Like the VIX, the SKEW is calculated by the CBOE. The SKEW is far less popular than the VIX, but has delivered much better signals than the VIX lately.
The SKEW Index in essence estimates the probability of a large decline. Readings of 135 suggest a 12% chance of a decline. Readings of 115 suggest a 6% chance of a large decline (large decline is defined as a two standard deviation move).
In other words, low extremes are bullish for stocks; high extremes are bearish for stocks.
As the chart shows, the SKEW is currently in ‘bullish for stocks’ territory.
This contradicts the more or less bearish message of the Equity Put/Call Ratio.
What do we make of this?
Past experience has taught me not to bet against the SKEW. It’s prudent to allow for higher prices, perhaps after a shallow correction.
To get the best possible read on the stock market, I look at sentiment (such as options data and other sentiment/money flow gauges, seasonality and technical signals.
Right now the technical picture for the Nasdaq-100 (Nasdaq: QQQ) is fairly crisp and clear. The Nasdaq-100 is moving towards serious resistance in a well-defined trend line channel. This resistance increases the odds of a sizeable top dramatically.
Simon Maierhofer is the publisher of the Profit Radar Report.
Follow Simon on Twitter @ iSPYETF

 

Smart Option Traders ‘Smelled’ the Latest Bounce

The Volatility Index (VIX) has not lived up to its contrarian indicator reputation, but there is another CBOE options index that’s provided some noteworthy signals. Say hello to the options indicator of the future – the SKEW.

A pilot literally monitors dozens of controls to navigate the aircraft safely through the air.

Like a pilot, the Profit Radar Report constantly monitors dozens of different stock market gauges.

Once a month, the Profit Radar Report publishes the Sentiment Picture. Radar like, the Sentiment Picture searches for sentiment extremes.

Shown below is the May 2013 Sentiment Picture (published on May 19), which plots the S&P 500 against five different sentiment gauges:

1) CBOE VIX
2) CBOE SKEW
3) CBOE Equity Put/Call Ratio
4) Percentage of bullish advisors polled by Investors Intelligence (II)
5) Percentage of bullish investors polled by the American Association for Individual Investors (AAII)

After many months of average readings, the May Sentiment Picture finally showed some extremes. Most notable were the up tick in the SKEW and the drop in the equity put/call ratio.

Unlike polls, the equity put/call ratio is an actual money flow indicator. It showed that investors are putting their money where their mouth is and indicated that risk for bulls was rising.

The actual sell signal was triggered based on technical analysis on May 28 with a target of 1,594 – 1,598 for the S&P 500.

The sell signal proved correct, but it was in contradiction to a bearish SKEW extreme, which is generally bullish for stocks.

On May 28, the SKEW was about the only indicator that suggested higher stock prices. Although the SKEW is quite accurate (see green and red lines on the second chart) its message was simply overruled by the majority of bearish indicators (but its message was only tucked away, not forgotten).

The SKEW – an options-based index like the VIX – in essence estimates the probability of a large decline. A reading of 135+ suggests a 12% chance of a large decline (two standard deviations). A reading of 115 or less suggests a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

The second chart plots the S&P 500 against the SKEW only.

A week later the lonely SKEW signal received backup by extremely bad breadth. Breadth was so bad, it’s actually good.

The June 6 article iSPYETF article noted a NYSE Advance/Decline Ratio that’s usually seen at market bottoms. Now there were two – the NYSE A/D ratio and the SKEW.

Both gauges have a good track record and on June 6 stocks staged a bullish intraday reversal after nearly touching the 1,598 down side target. It seems like options traders were the first to ‘know’ that a bounce was forthcoming.

A pilot is taught to always trust his instruments, not his instincts or emotions. Investment gauges aren’t as reliable as aircraft instruments, but investors should trust them much more than their own emotions. Does the bounce have legs?

The ‘instruments’ are telling me right now that stocks need to move above resistance (the lower lows, lower highs sequence has yet to be broken) or below support to trigger the next move. This may sound vague, but sometimes the market lacks clarity and when that happens it’s smart to stay on the sidelines.

It’s better to miss a trade than to lose money on a trade. The job of the Profit Radar Report is to spot and profit from high probability trades.

Despite Extreme VIX Movements, Option Traders are ‘Lukewarm’

According to the VIX, option-traders are complacent and have been complacent for many months. The bearish VIX implications however, have not been confirmed by two historically accurate options-based sentiment indicators.

The VIX soared 43% on Monday, collapsed 19% on Tuesday and is up nearly 30% today. Just before that, the VIX fell to the lowest reading since February 2007.

Although the CBOE Volatility Index (VIX) is rushing from one extreme to the next, options traders as a whole have been remarkably ‘non-committal’ or lukewarm from a sentiment point of view.

This sentiment deviation is illustrated by the chart below. The CBOE Equity Put/Call Ratio has been narrowing in a triangle shape formation void of extremes. The 2010, 2011 and 2012 market highs were preceded by at least one daily reading below 0.5 and a drop of the 10-day SMA below or at least close to 0.55.

The 2013 Equity Put/Call Ratio low was at 0.54 on March 6 (the 10-SMA has yet to fall below 0.6). The recent all-time highs caused no put/call sentiment extremes.

Quite to the contrary, the VIX has rushed from one extreme to the next. For that reason, the Profit Radar Report noted back in November that the: “VIX has been of no use as a contrarian indicator and will be put on ‘probation’ until it proves its worth again.” Yes, the VIX is still on probation.

A SKEWed Market?

The CBOE publishes another options-based index like the VIX, it’s called the CBOE SKEW Index. The SKEW in essence estimates the probability of a large decline.

Readings of 135+ suggest a 12% chance of a large decline (two standard deviations). A reading of 115 or less suggests a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

The chart below juxtaposes the SKEW against the S&P 500. Last week the SKEW fell as low as 117. This was odd as readings below 115 (dashed green line) are generally bullish for stocks.

Conclusion

The CBOE Equity Put/Call Ratio and SKEW index proved to be valuable contrarian indicators in 2010, 2011 and 2012. The current option-trader sentiment is not bullish, but it’s not as bearish as one would expect to see at a major market top.

To an extent, option-trader sentiment is in conflict with other bearish sentiment extremes discussed recently. When sentiment indicators conflict, technical analysis and support/resistance levels become even more valuable.

The April 10, Profit Radar Report highlighted key resistance at 1,593 and stated that: “A move above 1,593 followed by a move back below 1,590 will be a sell (as in go short) signal.”

As long as prices remain below key resistance, the trend is down until stocks find key support.